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Chapter 12.

b Price Discrimination and Economic Efficiency A competitive market operating in long-run equilibrium will operate in an efficient manner. That is to say that the quantity demanded will be the quantity produced at the equilibrium price. In competitive equilibrium there is a Producer Surplus (PS) that represents profit to the firm, and a Consumer Surplus (CS) that represents gains to the buyer. There are buyers willing to pay more than the market price, and because they are able to pay less than their value of the good, they benefit.

Figure 12.b.1 A market in competitive equilibrium. Area A represents the consumer surplus; area B represents the producer surplus. Market equilibrium is achieved at a price of 14 and an output of 12. A normal monopoly operating without practicing price discrimination will determine its output by setting MR=MC and reading up to the demand curve in order to find the price it should set. There are two things to note in this diagram; the first is that, while the monopolist has a greater Producer Surplus (PS) than would a firm in a competitive industry there still remains a Consumer Surplus (CS) that goes to the consumer. The second point to notice is that, from a standpoint of economic efficiency there is a loss to society. Specifically, a Dead Weight Loss (DWL) of 8 exists in this market.

Figure 12.b.2 A normal monopoly at profit-maximizing output. Area A is the Consumer Surplus, and area B+D+F is the Producer Surplus. Area C+E represents a Dead Weight Loss to society.

Price discrimination is the practice of a firm charging different prices to different consumers for the same product. The concept behind price discrimination is to charge each consumer exactly the amount he/she is willing to pay. Thus, for the first customer a higher price will be charged than for the second, and more will be charged to the second than to the third, etc. until the marginal consumer is reached. This marginal consumer is the one who values the good at its marginal cost. When each customer is charged at exactly his/her maximum willingness to pay (ie the height of the Demand curve), the firms MR revenue curve is exactly the same as its Demand Curve. Intuitively, each additional unit sold brings in revenue equal to the height of the demand curve at that quantity. Thus, under perfect price discrimination, the monopolists Producer Surplus (PS) will be the entire area below the demand curve, above the marginal cost curve, and to the left of the profit-maximizing output level.

Figure 12.b.3 A monopolist under conditions of perfect price discrimination. Area A+B represents the Producer Surplus. From the previous discussion of the monopolist, it should be clear that there are two key differences under conditions of perfect price discrimination. The first is that there is no Dead Weight Loss. This means that this pricing scheme is economically efficient and output is the same as it is under conditions of perfect competition (figure 12.b.1). The second difference is that there is no consumer surplus. The produced has captured the entire consumer surplus for itself as profit.